perc actuarial note july 2014

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COMMONWEALTH OF PENNSYLVANIA July 30, 2014

PUBLIC EMPLOYEE RETIREMENT COMMISSION

ACTUARIAL NOTE TRANSMITTAL

Bill ID: Amendment Numbers 07223 and 09253 to

House Bill Number 1353, Printers Number 2152

System: Public School Employees Retirement System and

State Employees Retirement System

Subject: Cash Balance Plan for New and Returning Members

SYNOPSIS

Amendment Number 07223 to House Bill Number 1353, Printers Number 2152, would

amend the Public School Employees Retirement Code and the State Employees Retirement

Code to mandate the establishment of a hybrid benefit tier known as a cash balance plan

for most new or returning employees hired on or after July 1, 2015, in the case of the Public

School Employees Retirement System (PSERS), and January 1, 2015, in the case of the

State Employees Retirement System (SERS).

More specifically, Amendment Number 07223 would amend the Public School Employees

Retirement Code to:

1) Effective July 1, 2015, establish a cash balance benefit tier applicable to all new

school employees or employees returning after a break in service. Current members

of PSERS in Class T-D would be eligible to make a one-time and irrevocable election

to participate in the cash balance plan with corresponding benefit provision changes.

2) Under the cash balance plan, school employees would become a member of Class T-

G and would be required to contribute 7.0% of compensation with a corresponding

employer contribution rate of 4.0% of compensation. After attaining 15 years of

service, the employer contribution rate would increase to 5% of compensation. The

employer and employee contributions would both be credited to the members

notational cash balance savings account, plus interest, at the rate of 4.0% annually.

3) Establish the superannuation requirement for members of Class T-G as age 55, with

the employees account balance (including all contributions, credit and interest)

being 100% vested immediately.


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Actuarial Note Transmittal

Amendment Numbers 07223 and 09253 to


4) Provide 50% of excess interest to any active members of the cash balance plan if

the Systems annual investment return over a five-year average is above 5%. This

additional employer credit would be credited to the members savings accounts on an

annual basis, if applicable.

5) Taper the employer contribution rate collars through Fiscal Year 2018-2019 to be

limited to 3% of total payroll. Currently, under Act 120 of 2010, the contribution

collar is 4.5% of total payroll.

6) Permit the PSERS Board to apply to the Pennsylvania Economic Development

Financing Authority (PEDFA) for a total of up to $6 billion in bond proceeds.

Amendment Number 07223 would also amend the State Employees Retirement Code to:

1) Effective January 1, 2015, establish a cash balance benefit tier applicable to most

new State employees or employees returning after a break in service. Sworn officers

of the Pennsylvania State Police and members of the judiciary would be exempt from

membership in the new benefit tier. Current members of SERS in Class AA would

be eligible to make a one-time and irrevocable election to participate in the cash

balance plan with corresponding benefit provision changes.

2) Under the cash balance plan, State employees would become a member of Class

QB and would be required to contribute 7.0% of compensation with a corresponding

employer contribution rate of 4.0% of compensation. After attaining 15 years of

service, the employer contribution rate would increase to 5% of compensation. The

employer and employee contributions would both be credited to the members

notational cash balance savings account, plus interest, at the rate of 4.0% annually.

3) Establish the superannuation requirement for members of Class QB as age 55, with

the employees account balance (including all contributions, credit and interest)

being 100% vested immediately.

4) Provide 50% of excess interest to any active members of the cash balance plan if

the Systems annual investment return over a five-year average is above 5%. This

additional employer credit would be credited to the members savings accounts on an

annual basis, if applicable.

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5) Taper the employer contribution rate collars through Fiscal Year 2018-2019 to be

limited to 3% of total payroll. Currently, under Act 120 of 2010, the contribution

collar is 4.5% of total payroll.

6) Permit the SERS Board to apply to the Pennsylvania Economic Development

Financing Authority (PEDFA) for a total of up to $3 billion in bond proceeds.

Amendment Number 09253 would amend the Public School Employees Retirement Code

to:

1) Remove the language in Amendment Number 07223 that would require theapplication for bond proceeds for PSERS be contingent on the percentage of Class T-

D members who opt in to the cash balance plan. This change in the language would

make the PSERS provisions consistent with the language for SERS.

DISCUSSION

The Retirement Codes and Systems

Currently, most full-time public school and state employees are members of either the

Public School Employees Retirement System (PSERS) or the State Employees RetirementSystem (SERS). Both PSERS and SERS are governmental, cost-sharing, multiple-employer

defined benefit pension plans. The designated purpose of the Public School Employees

Retirement System and the State Employees Retirement System is to provide retirement

allowances and other benefits, including disability and death benefits to public school and

state employees. As of June 30, 2013, there were approximately 797 participating

employers, generally school districts, area vocational-technical schools, and intermediate

units in PSERS, and as of December 31, 2013, approximately 104 Commonwealth and other

employers participating in SERS.

Membership in PSERS and SERS is mandatory for most school and state employees.

Certain other employees are not required but are given the option to participate. As of

June 30, 2013, there were 267,428 active members and 209,204 annuitant members of

PSERS, and as of December 31, 2013, there were 107,002 active members and 120,052

annuitant members of SERS.

For most members of both Systems, the basic benefit formula used to determine the normal

retirement benefit is equivalent to the product of 2.5% multiplied by the members years of

SYNOPSIS (CONTD)

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accumulated service credit (eligibility points) multiplied by the members final average

(highest three years) salary. Since the passage of Act 9 of 2001 (which increased the

accrual rate for most members from 2.0% to 2.5%), most members of PSERS are Class T-D

members and contribute 7.5% of compensation to PSERS, while most members of SERS are

Class AA members and contribute 6.25% of compensation to SERS. Within both Systems,

there are a number of additional membership classes with corresponding benefit accrual

and employee contribution rates that differ from the majority of school and state employees.

Act 120 of 2010 implemented major pension benefit reforms, including the establishment of

new benefit tiers applicable to most new members. Effective January 1, 2011, most new

members (including members of the General Assembly) are required to become members ofone of two membership classes, known as Class A-3 and Class A-4. Most new members

of SERS, other than State Police officers or members employed in a position for which a

class of service other than Class A or Class AA is credited or could be elected, become

members of Class A-3 beginning January 1, 2011 (or if a member of the General Assembly,

beginning December 1, 2010). Class A-3 members are eligible for an annuity based upon an

annual benefit accrual rate of 2% and have a corresponding employee contribution

requirement of 6.25% of compensation. As an alternative to Class A-3, an employee who

becomes a member of SERS on or after January 1, 2011, may elect Class A-4 membership

within 45 days of becoming a member of SERS. A Class A-4 member is eligible for an

annuity based upon an annual benefit accrual rate of 2.5% with a corresponding employeecontribution requirement equal to 9.3% of compensation.

Effective July 1, 2011, new members of PSERS are required to become members of one of

two membership classes, known as Class T-E and Class T-F. Most new members of

PSERS are required to become members of Class T-E beginning July 1, 2011. Class T-E

members are eligible for an annuity based upon an annual benefit accrual rate of 2% and

have a corresponding employee contribution of 7.5% of compensation. As an alternative to

Class T-E, an employee who becomes a member of PSERS on or after July 1, 2011, may

elect Class T-F membership within 45 days of becoming a member of PSERS. A Class T-F

member is eligible for an annuity based upon an annual benefit accrual rate of 2.5% with a

corresponding employee contribution requirement equal to 10.3% of compensation.

Under the Codes of both Systems, superannuation or normal retirement age is that date on

which a member may terminate service with the public employer and receive a full

retirement benefit without reduction. Under the Public School Employees Retirement

Code, superannuation or normal retirement age for most members is age 62 with at least

one full year of service, age 60 with 30 or more years of service, or any age with 35 years of

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service. Under the State Employees Retirement Code, superannuation or normal

retirement age for most members is age 60 with three years of service or any age with 35

years of service, while age 50 is the normal retirement age for members of the General

Assembly and certain public safety employees. For most members of the Systems who first

became members after the effective dates of Act 120, the superannuation requirement is

age 65 with a minimum of three years of service credit, or any combination of age and

service that totals 92 with at least 35 years of credited service, and age 55 for members of

the General Assembly and certain public safety employees.

Cash Balance Retirement Benefit Plan

Amendment Number 07223 to House Bill Number 1353, Printers Number 2152, would

establish a mandatory cash balance benefit tier applicable to most new or returning

employees of PSERS and SERS, beginning July 1, 2015, in the case of PSERS, and January

1, 2015, in the case of SERS.

A cash balance plan is a type of defined benefit plan with a defined contribution-like

portability component. A cash balance plan calculates benefits in a manner similar to a

defined contribution plan. Under a cash balance arrangement, benefits are accrued

throughout a workers years of employment. Similar to what tends to occur with defined

contribution plans, employees who move from employer to employer frequently or otherwiseleave service early will tend to benefit more from a cash balance plan than a traditional

defined benefit plan, because the accrued benefits will tend to be greater than would be the

case under a traditional defined benefit plan. Conversely, long-service employees will tend

to benefit less from a cash balance plan arrangement as compared with a traditional

defined benefit plan, because the portion of the benefit accrued in later years of service will

tend to be less than under a traditional defined benefit plan.

A cash balance plan is classified as a defined benefit plan because the employer bears the

investment risks and rewards along with the mortality risk if the employee elects to receive

benefits in the form of an annuity and lives beyond the anticipated retired life expectancy.

Unlike a traditional defined benefit plan, a cash balance plan establishes allocations to a

hypothetical individual account (the cash balance) for each participant (individual account

balances are segregated for accounting purposes only). Benefits under cash balance plans

may be paid as a lump sum or annuitized over the retirees expected remaining lifetime.

The cash balance retirement benefit calculation would differ from the current traditional

defined benefit formula. Rather than receiving an annuity based upon the current benefit

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formula (accrual rate x years of service x final average salary), the cash balance benefit

would be equal to the value of all accumulated employee and employer contributions plus

interest credited to the members cash balance ledger account at the time of retirement. A

member would be entitled to elect one of three benefit options at the time of separation: 1) a

lifetime annuity based upon the total value of the members account, plus interest (if

superannuated); 2) delay receipt of benefits until superannuation age by vesting; or 3) elect

to receive a lump-sum distribution of employee contributions and interest, but forfeiting the

employer contribution and interest component and any entitlement to a future annuity.

Cash balance plans and other types of hybrid defined benefit plans have been replacing

traditional retirement plans in the private sector for many years. Many employers,including some public employers, have moved to cash balance plans in an attempt to control

plan costs, reduce employer contribution volatility, and shift some of the inherent risk

associated with maintaining a defined benefit plan from the employer to the employee.

Benefit costs under the cash balance plan proposal in the amendment will be lower than

the current traditional defined benefit plan. A significant part of this cost difference is due

to the difference between the guaranteed investment rate credited on employee accounts

(4% under the amendment for the first 15 years of service, then 5% thereafter) and

investment return assumptions on pension fund assets (currently 7.5%). Additionally,

because the amendment penalizes members for early termination (prior to age 55) byrequiring members to forfeit the employer contribution component of the cash balance

savings account (or defer receipt of an annuity until age 55), the recouping of these

employer contributions may serve to further reduce costs.

The cash balance plan will also shift inflation risk from the employer to the employee since

the final retirement benefit is a function of earnings over the working lifetime of the

employee instead of the final years when such earnings are typically the highest.

The cash balance benefit proposal in the amendment differs from most private sector plans

in several respects. The proposed cash balance plan is less generous and less portable than

a typical cash balance plan. Under the amendment, employer contributions with interest

are forfeited if a member elects to receive a lump sum of the accumulated member

contributions with interest. In the private sector, employees are generally 100% vested in

both the employee and employer contributions to the cash balance account, with interest,

after three years of service (the minimum required by federal law). Employees in the

private sector are typically entitled to a lump sum of the entire vested cash balance account

upon termination or retirement. Under the amendment, employees would not be entitled to

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the employer contributions with interest or to annuitize the cash balance account until

reaching age 55. The proposal in the amendment also requires an employee contribution of

7.0% of pay, while private sector cash balance plans often require no employee

contributions.

Amendment Number 07223 would not affect the retirement benefit rights of current active

members of the Systems (unless they voluntarily elect to participate in the cash balance

plan). Instead, the amendment seeks to create new benefit tiers within PSERS and SERS

applicable to employees who first become members or are returning after a break in service

on or after the year 2015.

The amendments major design features are described below.

1) Mandatory Membership: Membership in Class T-G and Class QB would be

mandatory for most new school or State employees hired or returning after a break

in service on or after July 1, 2015, or January 1, 2015, respectively. Membership

would be mandatory regardless of the number of hours or days worked annually.

The current minimum requirement for membership in PSERS (500 hours of work)

would be eliminated. For SERS, only sworn officers of the Pennsylvania State

Police and members of the judiciary (including district magistrates) would be

exempt from membership in the new benefit tier.

2) Optional Membership: Current school or State employees who are members of

Class T-D or Class AA may make a one-time irrevocable election to participate in

the cash balance plan, with consent to the following changes to the members

benefit provisions: a reduction in the members contribution rate by 1.0% of

compensation; an increase in the final average salary calculation from the highest

three years to the highest five years; and a modification of the Option 4 lump-sum

withdrawal to be actuarially neutral to the System, if selected upon retirement.

New members of the Systems hired after the effective dates of Act 120 (Classes T-

E and T-F in PSERS, and Classes A-3 and A-4 in SERS) are prohibited from

electing to participate in the cash balance plan.

3) Contributions: The contribution rate for Class T-G and Class QB members

would be equal to 7.0% of compensation, with a corresponding employer

contribution rate of 4.0% of compensation for the first 15 years of service, followed

by an increase in the employer contribution rate to 5.0% of compensation for all

years of service thereafter. The employer and employee contributions would both

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be credited to the members cash balance savings account, plus interest, at the rate

of 4.0% annually.

4) Excess Interest: Active members of the cash balance plans would be eligible to

receive 50% of excess interest credited to their savings accounts in the event the

Systems annual investment returns over a five-year average are above 5%. The

excess interest shall be calculated and allocated proportionately between the

members savings accounts and the accrued actuarial liabilities of the current

defined benefit plans of the Systems. The additional employer credit would be

credited to the members savings accounts on an annual basis, if applicable.

5) Vesting: Class T-G and Class QB members would be 100% vested in the employee

contribution portion of the cash balance plan from the first day of membership.

Members leaving service before age 55 may elect to defer receipt of an annuity

until attaining superannuation age, or may elect to receive a refund of member

contributions with interest. Members electing to receive a refund of contributions

would forfeit eligibility for a future annuity benefit. The employer-share of

contributions and interest would be returned to the State accumulation account.

6) Superannuation: The superannuation requirement for new members of Class T-

G and Class QB would be age 55. The cash balance benefit would be equal to thepresent value of all accumulated employee and employer contributions plus

interest credited to the members cash balance savings account at the time of

retirement and would be paid to the member in the form of a lifetime annuity. An

eligible member would be entitled to elect to receive a lump-sum distribution of

employee contributions and interest, but would forfeit the employer contributions

and interest component and any entitlement to a future annuity.

7) Service Credit Purchase: Class T-G and Class QB members would be

prohibited from purchasing previous school service or creditable nonschool service

except for an approved leave of absence (such as military service). The election of

multiple service membership is prohibited for members who only have credit in

Class T-G or Class QB. Multiple service membership involves the combining of

PSERS service and SERS service for retirement credit purposes. An individual

with prior service credit in one of the retirement systems who, due to a change in

employment status, becomes a member of the other retirement system may elect to

become a multiple service member. Because vesting in a cash balance plan is

immediate and no final average salary calculation is used to determine retirement

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benefits, multiple service membership is irrelevant to the cash balance

environment.

8) Retirement Benefit Entitlement: Upon termination of service, any Class T-G or

Class QB member who is eligible to receive an annuity would be entitled to receive

a lifetime annuity with a present value equal to the balance of the members

savings account. Class T-G and Class QB members (as with all PSERS and SERS

members) would be entitled to elect various member benefit distribution options

intended to provide members with flexibility in deciding the manner in which

members benefits are disbursed and to ensure that members who choose to do so

have the ability to provide a reliable benefit stream to their designated survivorbeneficiaries. A superannuated member may elect to receive a lump-sum

distribution of employee contributions and interest in lieu of an annuity, but would

forfeit the employer contribution and interest component of the cash balance

savings account and any entitlement to a future annuity.

9) Option 4: Members of Class T-G, Class QB, and currently active members who

voluntarily participate in the cash balance plan may elect the Option 4 lump-sum

withdrawal upon retirement, but the manner of determining the net annuity will

be modified to make the option actuarially cost neutral to the Systems. The lump-

sum withdrawal option is currently prohibited for new members of the Systemshired after the effective dates of Act 120.

10) Disability Benefit: The amendment would amend the pertinent sections of the

PSERS and SERS Codes to provide for a disability benefit if a Class T-G or Class

QB member becomes disabled. A member would be eligible to receive an annuity

regardless of reaching superannuation age, but with the annuity being limited to

the present value of the members savings account at the time of retirement.

Additionally, Class T-G members in PSERS can opt to participate in a Long-Term

Disability Group Insurance Program, which is permitted, but not required, to be

established by the PSERS Board. The Long-Term Disability Insurance Program

would be sponsored by the Board and funded by and for Class T-G members. The

organization and administration of the program would be at the sole discretion of

the Board.

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11) Death Benefit: If a member dies prior to retirement, the total value of the

members cash balance savings account (both employer and employee

contributions, plus interest accrued) would be paid in a lump sum to the members

designated beneficiaries or estate. Beyond payment of the members savings

account balance in a lump sum, there are no special death benefit provisions to

provide for the surviving beneficiaries of a Class T-G or Class QB member.

12) Pension Obligation Bonds: As provided in Section 8502(r) and Section 5902(r)

in Amendment Number 07223 to the bill, the PSERS and SERS Boards are

authorized to apply to the Pennsylvania Economic Development Financing

Authority (PEDFA) for a total of up to $6 billion for PSERS and $3 billion forSERS in bond proceeds. Based on the intent of the amendments sponsor, the

borrowing from PEDFA would be required to occur within the first year after the

effective date of the proposal. The amendment also repeals Section 13 of Act 120,

which prohibited the issuance of pension obligation bonds as a means for funding

the liabilities of PSERS and SERS.

Pension Obligation Bonds

Pension obligation bonds (POBs) are a form of taxable general obligation bonds that

governments issue to finance pension obligations. POBs may be employed to transform acurrent pension obligation into a long-term, fixed obligation of the government. While

POBs may provide an avenue to alleviate fiscal distress and reduce pension liabilities, they

also pose certain risks. For this strategy to be successful, pension fund investment returns

must exceed the taxable borrowing rate on the bond issue, resulting in a net gain over time.

The timing of the bond issuance is another area of concern. In order to obtain the best

possible gains, the debt must be incurred when the borrowing costs are low. There is also a

greater risk that investment returns will prove insufficient during periods of liberal

monetary policy (i.e., quantitative easing). The net proceeds of a pension bond (after

expenses of issuance) are deposited into the pension fund and applied to reduce the

unfunded actuarial liability. Like all pension assets, they are projected to earn interest at

the plans assumed discount rate, and the value of the bond asset is determined in

accordance with that assumption. Unlike other pension assets, however, a bond imposes

debt service costs upon the public employer, in addition to the contribution required to

maintain the pension plan. In short, for the bond to be profitable, it must generate both the

pension plans assumed earnings rate and the debt service rate. A detailed analysis

published in July 2014 by the Center for Retirement Research at Boston College found that

pension obligation bonds are rarely, if ever, profitable to the government employer. The full

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study is accessible at http://crr.bc.edu/wp-content/uploads/2014/07/slp_40_508rev.pdf. Since this is

essentially a budgetary issue, rather than an actuarial matter, the Office of the Budget has

submitted a cost projection related to the issuance expenses and debt service costs for the

bond proposed by this bill. The net savings must cover the debt service on the bond.

Special Membership Classes

Within SERS, there are a number of special membership classes entitled to enhanced

retirement benefits, reduced superannuation requirements or both. These include all

members of the judiciary, members of the General Assembly, certain enforcement officers

and Pennsylvania State Police Officers. Officers of the Pennsylvania State Police and

members of the judiciary will be unaffected by the benefit changes of the amendment.

Under the amendment as written, however, membership in Class QB would be mandatory

for members of the General Assembly and certain other public safety employees. These

groups of employees would no longer be entitled to special benefit provisions that similarly

situated employees currently receive. Consequently, these employees would be entitled to

benefits that are significantly less valuable than their peers who became members before

the effective date of the amendment. Due to the hazardous nature of their duties, it may be

desirable to retain some type of enhanced benefit for hazardous duty personnel in the form

of special in-service death, disability or retirement provisions.

Determination of Employer Normal Cost

Section 8328 of the PSERS Code and Section 5508 of the SERS Code specify the methods to

be used by the actuaries of the respective systems to determine the employer normal

contribution rate or employer normal cost and the total employer contribution rate, which

consists of both the normal cost and the contributions required to fund the accrued

liabilities of each plan, plus any amortization contribution requirement.

Both the PSERS and SERS Codes require the normal cost to be determined using "... a level

percentage of the compensation of the average new active member...." However, the

Systems apply different interpretations to the language. Using the SERS interpretation,

the average new member, or entrant, to the System currently earns a benefit at a 2.0%

accrual rate. However, if enacted, the proposal would require the normal cost to be

calculated on new members in Class QB. This would result in a normal cost calculation of

0.0% that would understate the true cost of SERS, because in the early years of the reduced

benefit tier, the majority of members would remain in benefit classes entitling them to an

annual benefit accrual of greater value than for new members of Class QB. In the short

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term, the understated normal cost would generate an unfunded actuarial accrued liability

in SERS. This would occur because reducing the benefit accrual rate for new members only

would not affect the present value of benefits for current members, but would affect the

normal cost calculation.

In contrast, PSERS uses a more traditional method of determining normal cost under the

entry age normal actuarial cost method. The traditional method develops the normal cost

rate based upon a blending of accrual rates (and subsequently, the costs) attributable to all

active members, rather than new entrants only. Use of the traditional method would help

to achieve the presumed long-term cost reduction goals of the proposal by both gradually

reducing the normal cost and preventing the creation of unfunded actuarial accruedliabilities.

Anci llary Issues

Effective Date for Members of the General Assembly. In the case of members of the General

Assembly who enter office on or after December 1, 2014, and before the amendments

effective date of January 1, 2015, for SERS, the effective date for membership in Class QB

shall be December 1, 2014.

Pension Forfeiture Act. Under Act 140 of 1978, known as the Public Employee PensionForfeiture Act (43 P.S.1311-1315), a public official or public employee who is convicted

or pleads guilty or no defense to a crime related to public office or public employment is

disqualified to receive a retirement or other benefit or payment of any kind except a return

without interest of the contributions paid into a retirement system. The amendment does

not include any provisions for the forfeiture of a retirement benefit for members of the cash

balance plans.

Internal Revenue Code. The Commissions actuary points out that the proposals use of a

7.5% discount assumption with a maximum 5.25% earnings rate on deposits (4% plus

maximum excess interest) would be prohibited by the IRS for private sector plans, even

before the adoption of the Pension Protection Act. The effect on plan tax qualification

should be examined.

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SUMMARY OFACTUARIAL COST IMPACT

The Commissions consulting actuary has reviewed the amendments and the actuarial cost

estimates provided to the Commission by the consulting actuaries for PSERS and SERS

and has prepared an actuarial note.

The Commissions consulting actuary has estimated the total cost savings for PSERS and

SERS over the 30 year projection period of $19.8 billion and $10.7 billion

respectively. Though significant, these projected savings differ from the $26.8 billion in

savings projected by Buck Consultants for PSERS and the $15.3 billion in savings projected

by Hay Group for SERS, and reflect the generally more conservative approach of the

Commissions consulting actuary. The consulting actuarys results assume higher employer

contributions in the later years of the projection, based upon the consulting actuarys

assessment of cash flow and benefit projection data provided to the Commission staff by

Hay and Buck, including estimates as to the population that will be covered by the cash

balance plan and anticipated separation rates. Additionally, in the case of SERS, the

consulting actuary for the Commission assumed that legacy defined benefit plan members

will continue to have a normal cost closer to current levels instead of a normal cost of zero.

Furthermore, in the private sector, the transition to a cash balance plan is normally

addressed by selecting a low interest crediting rate and by investing plan assets

conservatively to insulate the fund from market volatility. The conservative asset

allocation is targeted to ensure a high probability that returns will exceed the guaranteed

cash balance plan crediting rate. Retention of the long-term investment assumption of7.5% utilized by Buck and Hay in their cost estimates may somewhat overstate the long-

term cost savings of the proposal. The Commissions consulting actuary developed a model

that assumes a gradual reduction in the assumed rate of return as cash balance plan

membership increases and represents a larger share of plan liabilities relative to the

liabilities of legacy defined benefit plan members.

In its analysis, the Commissions consulting actuary developed two scenarios for each of the

projections. The first scenario assumes the investment return assumption for both Systems

remains at 7.50%. The second scenario assumes the investment return assumption is

blended to reflect a gradual reduction of market risk that the funds are exposed to,thereby gradually reducing the investment return assumption. Additionally, the tables

include a projection if only the pension obligations bonds are implemented. The results of

this analysis are summarized in the following tables.

Tables 1 and 2 show the projection of employer contributions for PSERS in comparison with

existing law over the 30-year projection period through Fiscal Year 2043-44. Table 1 shows

the employer contributions as a percentage of payroll, and Table 2 shows the employer

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contributions in dollar amounts (in billions). The first column under the cash balance plan

proposal shows the projection of employer contributions assuming a 7.50% investment

return assumption. The second column shows the projection of employer contributions

using a blended investment return assumption, and the last column projects the employer

contributions for the pension obligation bonds only. Similarly, the projection of employer

contributions for SERS over the 30-year projection period through Fiscal Year 2043-44 are

displayed in tables 3 and 4.

Tables 5 and 6 show the projection of funded ratio and unfunded liabilities, respectively, for

PSERS in comparison with existing law over the 30-year projection period through Fiscal

Year 2043-44. The first column under the cash balance plan proposal shows the projection

of funded ratio/unfunded liability assuming a 7.50% investment return assumption. The

second column shows the projection of funded ratio/unfunded liability using a blended

investment return assumption, and the last column projects the funded ratio/unfunded

liability for the pension obligation bonds only. Likewise, Tables 7 and 8 show the projection

of funded ratio and unfunded liabilities for SERS, respectively, over the 30-year projection

period through Fiscal Year 2043-44.

SUMMARY OFACTUARIAL COST IMPACT (CONTD)SUMMARY OFACTUARIAL COST IMPACT (CONTD)

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TABLE 1

Public School Employees' Retirement System

Projection of Employer Contributions

Fiscal Year Existing Law Cash Balance/Funding Reform

PensionObligation

Bonds Only

7.5%Rate of Return Blended Return

7.5%Rate of Return

2015 20.5% 20.5% 20.5% 20.5%

2016 25.0% 23.5% 23.5% 25.0%

2017 28.1% 26.5% 26.5% 28.1%

2018 29.0% 25.9% 25.9% 26.0%

2019 30.1% 26.8% 26.8% 27.0%

2020 30.9% 27.4% 27.4% 27.8%

2021 30.8% 27.2% 27.2% 27.7%

2022 30.8% 27.1% 27.1% 27.7%

2023 31.1% 27.2% 27.2% 28.0%

2024 31.1% 27.2% 27.2% 28.0%

2025 31.2% 27.2% 27.2% 28.1%

2026 31.3% 27.2% 27.2% 28.2%

2027 31.4% 27.2% 27.2% 28.2%2028 31.5% 27.3% 27.2% 28.3%

2029 31.6% 27.3% 27.2% 28.3%

2030 31.6% 27.3% 27.3% 28.4%

2031 31.7% 27.4% 27.4% 28.4%

2032 31.8% 27.5% 27.5% 28.5%

2033 31.9% 27.6% 27.6% 28.6%

2034 32.0% 27.8% 27.8% 28.6%

2035 32.1% 28.0% 28.0% 28.7%

2036 18.5% 14.5% 14.6% 15.1%

2037 15.1% 11.1% 11.3% 11.6%

2038 13.4% 9.6% 9.8% 9.9%

2039 11.6% 7.9% 8.2% 8.0%

2040 9.9% 6.2% 6.7% 6.2%

2041 8.3% 4.8% 5.4% 4.7%

2042 6.9% 7.1% 7.8% 6.9%

2043 5.5% 5.6% 6.5% 5.5%

2044 4.4% 4.6% 5.7% 4.4%

SUMMARY OFACTUARIAL COST IMPACT (CONTD)

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TABLE 2

Public School Employees' Retirement SystemProjection of Employer Contributions

(in billions)

FiscalYear

ExistingLaw Cash Balance/Funding Reform

Pension ObligationBonds Only

7.5%Rate ofReturn

Increase/(Decrease)

BlendedReturn

Increase/(Decrease)

7.5%Rate ofReturn

Increase/(Decrease)

2015 $ 2.812 $ 2.812 $ - $ 2.812 $ - $ 2.812 $ -

2016 $ 3.520 $ 3.309 $ (0.211) $ 3.309 $ (0.211) $ 3.520 $ -

2017 $ 4.059 $ 3.832 $ (0.226) $ 3.832 $ (0.226) $ 4.059 $ -

2018 $ 4.314 $ 3.847 $ (0.467) $ 3.846 $ (0.469) $ 3.866 $ (0.448)

2019 $ 4.596 $ 4.101 $ (0.495) $ 4.097 $ (0.499) $ 4.133 $ (0.463)

2020 $ 4.856 $ 4.317 $ (0.538) $ 4.313 $ (0.543) $ 4.376 $ (0.480)

2021 $ 4.989 $ 4.409 $ (0.580) $ 4.403 $ (0.586) $ 4.493 $ (0.496)

2022 $ 5.138 $ 4.518 $ (0.619) $ 4.510 $ (0.627) $ 4.624 $ (0.514)

2023 $ 5.326 $ 4.669 $ (0.657) $ 4.660 $ (0.666) $ 4.795 $ (0.532)

2024 $ 5.498 $ 4.804 $ (0.694) $ 4.794 $ (0.704) $ 4.948 $ (0.550)

2025 $ 5.674 $ 4.944 $ (0.730) $ 4.933 $ (0.741) $ 5.104 $ (0.570)

2026 $ 5.848 $ 5.084 $ (0.764) $ 5.072 $ (0.776) $ 5.258 $ (0.590)

2027 $ 6.025 $ 5.226 $ (0.798) $ 5.214 $ (0.811) $ 5.414 $ (0.610)2028 $ 6.201 $ 5.370 $ (0.830) $ 5.358 $ (0.843) $ 5.569 $ (0.632)

2029 $ 6.377 $ 5.516 $ (0.861) $ 5.505 $ (0.872) $ 5.723 $ (0.654)

2030 $ 6.556 $ 5.667 $ (0.889) $ 5.657 $ (0.899) $ 5.879 $ (0.677)

2031 $ 6.742 $ 5.825 $ (0.916) $ 5.818 $ (0.924) $ 6.041 $ (0.700)

2032 $ 6.929 $ 5.989 $ (0.941) $ 5.985 $ (0.944) $ 6.205 $ (0.725)

2033 $ 7.120 $ 6.165 $ (0.954) $ 6.166 $ (0.953) $ 6.370 $ (0.750)

2034 $ 7.317 $ 6.351 $ (0.966) $ 6.359 $ (0.958) $ 6.541 $ (0.776)

2035 $ 7.518 $ 6.544 $ (0.974) $ 6.562 $ (0.956) $ 6.714 $ (0.803)

2036 $ 4.447 $ 3.470 $ (0.977) $ 3.500 $ (0.947) $ 3.615 $ (0.832)

2037 $ 3.700 $ 2.723 $ (0.977) $ 2.769 $ (0.931) $ 2.839 $ (0.861)

2038 $ 3.381 $ 2.409 $ (0.971) $ 2.476 $ (0.905) $ 2.490 $ (0.891)

2039 $ 2.997 $ 2.035 $ (0.962) $ 2.127 $ (0.870) $ 2.075 $ (0.922)

2040 $ 2.606 $ 1.645 $ (0.961) $ 1.767 $ (0.839) $ 1.652 $ (0.954)

2041 $ 2.254 $ 1.295 $ (0.959) $ 1.455 $ (0.799) $ 1.266 $ (0.988)

2042 $ 1.935 $ 1.968 $ 0.033 $ 2.173 $ 0.238 $ 1.935 $ 0.000

2043 $ 1.573 $ 1.607 $ 0.034 $ 1.867 $ 0.294 $ 1.573 $ 0.000

2044 $ 1.282 $ 1.354 $ 0.072 $ 1.679 $ 0.398 $ 1.282 $ 0.000

Total $ (19.778) $ (18.568) $ (16.416)


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TABLE 4

State Employees' Retirement SystemProjection o f Employer Contributions

(in billions)

FiscalYear

ExistingLaw Cash Balance/Funding Reform

Pension ObligationBonds Only

7.5%Rate ofReturn

Increase/(Decrease

BlendedReturn

Increase/(Decrease)

7.5%Rate ofReturn

Increase/(Decrease)

2015 $ 1.254 $ 1.254 $ - $ 1.254 $ - $ 1.254 $ -

2016 $ 1.576 $ 1.482 $ (0.095) $ 1.482 $ (0.095) $ 1.576 $ -2017 $ 1.917 $ 1.722 $ (0.195) $ 1.722 $ (0.195) $ 1.742 $ (0.175)

2018 $ 2.035 $ 1.716 $ (0.319) $ 1.713 $ (0.322) $ 1.739 $ (0.296)

2019 $ 2.045 $ 1.719 $ (0.326) $ 1.715 $ (0.330) $ 1.749 $ (0.296)

2020 $ 2.056 $ 1.722 $ (0.333) $ 1.718 $ (0.338) $ 1.759 $ (0.296)

2021 $ 2.066 $ 1.726 $ (0.341) $ 1.721 $ (0.346) $ 1.770 $ (0.296)

2022 $ 2.077 $ 1.729 $ (0.348) $ 1.724 $ (0.353) $ 1.781 $ (0.296)

2023 $ 2.089 $ 1.733 $ (0.356) $ 1.728 $ (0.361) $ 1.793 $ (0.296)

2024 $ 2.101 $ 1.738 $ (0.363) $ 1.733 $ (0.368) $ 1.804 $ (0.296)

2025 $ 2.113 $ 1.743 $ (0.370) $ 1.739 $ (0.374) $ 1.817 $ (0.296)

2026 $ 2.126 $ 1.748 $ (0.377) $ 1.746 $ (0.380) $ 1.829 $ (0.296)

2027 $ 2.139 $ 1.754 $ (0.384) $ 1.754 $ (0.385) $ 1.842 $ (0.296)

2028 $ 2.152 $ 1.761 $ (0.391) $ 1.763 $ (0.389) $ 1.856 $ (0.296)

2029 $ 2.166 $ 1.768 $ (0.398) $ 1.775 $ (0.391) $ 1.869 $ (0.296)

2030 $ 2.180 $ 1.776 $ (0.404) $ 1.788 $ (0.392) $ 1.884 $ (0.296)

2031 $ 2.195 $ 1.791 $ (0.404) $ 1.809 $ (0.386) $ 1.898 $ (0.296)

2032 $ 2.210 $ 1.804 $ (0.406) $ 1.830 $ (0.380) $ 1.914 $ (0.296)

2033 $ 2.225 $ 1.818 $ (0.408) $ 1.855 $ (0.371) $ 1.929 $ (0.296)

2034 $ 2.241 $ 1.833 $ (0.409) $ 1.883 $ (0.359) $ 1.945 $ (0.296)

2035 $ 2.258 $ 1.849 $ (0.409) $ 1.915 $ (0.343) $ 1.962 $ (0.296)

2036 $ 2.275 $ 1.867 $ (0.408) $ 1.952 $ (0.323) $ 1.979 $ (0.296)

2037 $ 2.293 $ 1.887 $ (0.406) $ 1.993 $ (0.299) $ 1.996 $ (0.296)2038 $ 2.311 $ 1.908 $ (0.403) $ 2.041 $ (0.270) $ 2.014 $ (0.296)

2039 $ 2.329 $ 1.923 $ (0.406) $ 2.087 $ (0.242) $ 2.033 $ (0.296)

2040 $ 2.349 $ 1.939 $ (0.410) $ 2.139 $ (0.209) $ 2.052 $ (0.296)

2041 $ 1.894 $ 1.480 $ (0.414) $ 1.724 $ (0.170) $ 1.598 $ (0.296)

2042 $ 1.559 $ 1.142 $ (0.417) $ 1.436 $ (0.123) $ 1.263 $ (0.296)

2043 $ 1.155 $ 0.735 $ (0.421) $ 1.086 $ (0.069) $ 0.859 $ (0.296)

2044 $ 0.902 $ 0.478 $ (0.424) $ 0.895 $ (0.007) $ 0.606 $ (0.296)

Total $ (10.743) $ (8.569) $ (8.175)


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TABLE 5


Projection of Funded Ratio


PensionObligation

Bonds Only


7.5%Rate of Return

2015 59.8% 59.8% 59.8% 59.8%

2016 58.5% 64.6% 64.6% 64.8%

2017 57.1% 63.3% 63.3% 63.7%

2018 56.4% 62.4% 62.4% 62.9%

2019 57.7% 63.5% 63.5% 64.0%

2020 59.0% 64.6% 64.6% 65.1%

2021 59.9% 65.4% 65.4% 65.8%

2022 61.2% 66.5% 66.6% 67.0%

2023 62.7% 67.8% 67.9% 68.2%

2024 64.3% 69.3% 69.4% 69.6%

2025 66.0% 71.0% 71.0% 71.1%

2026 67.9% 72.8% 72.8% 72.8%

2027 70.0% 74.7% 74.8% 74.6%2028 72.2% 76.9% 76.9% 76.5%

2029 74.5% 79.1% 79.2% 78.6%

2030 77.0% 81.6% 81.6% 80.8%

2031 79.6% 84.2% 84.2% 83.1%

2032 82.3% 87.1% 87.0% 85.5%

2033 85.2% 90.1% 89.9% 88.1%

2034 88.3% 93.4% 93.1% 90.8%

2035 91.6% 96.9% 96.4% 93.7%

2036 93.1% 98.5% 97.8% 94.8%

2037 94.2% 99.6% 98.8% 95.5%

2038 95.1% 100.6% 99.5% 95.9%

2039 95.9% 101.7% 100.3% 96.2%

2040 96.4% 102.7% 100.9% 96.2%

2041 96.7% 103.5% 101.3% 96.0%

2042 96.8% 104.8% 102.1% 96.0%

2043 96.7% 105.9% 102.6% 95.9%

2044 96.1% 107.0% 103.0% 95.3%


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TABLE 6


Projection of Unfunded Liability

(in billions)


PensionObligation

Bonds Only


7.5%Rate of Return

2015 $38.458 $ 38.458 $38.458 $38.458

2016 $40.866 $ 34.856 $34.856 $34.645

2017 $43.418 $ 37.233 $37.228 $36.731

2018 $45.424 $ 39.230 $39.217 $38.699

2019 $45.438 $ 39.205 $39.182 $38.689

2020 $45.359 $ 39.073 $39.036 $38.601

2021 $45.615 $ 39.261 $39.209 $38.865

2022 $45.423 $ 38.973 $38.904 $38.699

2023 $45.011 $ 38.451 $38.365 $38.335

2024 $44.325 $ 37.641 $37.539 $37.718

2025 $43.355 $ 36.534 $36.419 $36.844

2026 $42.096 $ 35.123 $34.999 $35.7072027 $40.521 $ 33.378 $33.252 $34.286

2028 $38.621 $ 31.285 $31.168 $32.573

2029 $36.376 $ 28.830 $28.737 $30.552

2030 $33.752 $ 25.984 $25.933 $28.193

2031 $30.725 $ 22.721 $22.736 $25.475

2032 $27.270 $ 19.026 $19.139 $22.378

2033 $23.349 $ 14.858 $15.106 $18.867

2034 $18.898 $ 10.154 $10.583 $14.885

2035 $13.896 $ 4.901 $ 5.566 $10.415

2036 $11.691 $ 2.451 $ 3.416 $ 8.811

2037 $10.088 $ 0.608 $ 1.948 $ 7.884

2038 $ 8.688 $ (1.019) $ 0.777 $ 7.242

2039 $ 7.572 $ (2.904) $ (0.564) $ 6.974

2040 $ 6.789 $ (4.569) $ (1.589) $ 7.136

2041 $ 6.361 $ (6.008) $ (2.255) $ 7.758

2042 $ 6.270 $ (8.278) $ (3.604) $ 7.771

2043 $ 6.605 $ (10.354) $ (4.592) $ 8.219

2044 $ 8.018 $ (12.414) $ (5.379) $ 9.754


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TABLE 7

State Employees' Retirement System

Projection of Funded Ratio

FiscalYear Existing Law Cash Balance/Funding Reform

PensionObligation

Bonds Only


7.5%Rate of Return

2015 58.6% 58.6% 58.6% 58.6%

2016 58.5% 65.3% 65.3% 65.3%

2017 58.6% 65.6% 65.6% 65.9%

2018 60.2% 67.2% 67.2% 67.4%

2019 61.6% 68.4% 68.4% 68.6%

2020 63.0% 69.6% 69.6% 69.8%

2021 64.4% 70.8% 70.8% 70.9%

2022 65.8% 72.0% 72.0% 72.0%

2023 67.2% 73.2% 73.2% 73.2%

2024 68.6% 74.4% 74.5% 74.3%

2025 69.9% 75.7% 75.7% 75.4%

2026 71.3% 77.0% 77.0% 76.6%

2027 72.7% 78.3% 78.2% 77.7%

2028 74.2% 79.6% 79.5% 78.9%

2029 75.6% 81.1% 80.9% 80.1%

2030 77.1% 82.5% 82.3% 81.3%

2031 78.7% 84.1% 83.6% 82.6%

2032 80.3% 85.7% 85.1% 83.8%

2033 81.9% 87.3% 86.5% 85.2%

2034 83.5% 89.1% 88.0% 86.5%

2035 85.2% 90.9% 89.5% 87.9%

2036 87.0% 92.7% 91.0% 89.3%

2037 88.7% 94.6% 92.5% 90.7%

2038 90.5% 96.6% 94.0% 92.2%2039 92.4% 99.1% 96.0% 93.7%

2040 94.2% 101.8% 98.0% 95.2%

2041 96.1% 104.6% 100.1% 96.7%

2042 97.3% 106.8% 101.6% 97.6%

2043 98.2% 108.7% 102.7% 98.1%

2044 98.5% 110.1% 103.2% 98.1%


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TABLE 8

State Employees' Retirement System

Projection of Unfunded Liability

(in billions)


PensionObligation

Bonds Only


7.5%Rate of Return

2015 $18.276 $18.276 $18.276 $18.276

2016 $18.773 $15.694 $15.690 $15.662

2017 $19.131 $15.898 $15.888 $15.788

2018 $18.814 $15.502 $15.483 $15.401

2019 $18.520 $15.235 $15.209 $15.158

2020 $18.207 $14.942 $14.908 $14.900

2021 $17.871 $14.618 $14.577 $14.623

2022 $17.511 $14.262 $14.215 $14.327

2023 $17.129 $13.874 $13.824 $14.013

2024 $16.720 $13.451 $13.400 $13.677

2025 $16.282 $12.990 $12.944 $13.319

2026 $15.814 $12.488 $12.453 $12.9362027 $15.313 $11.942 $11.928 $12.526

2028 $14.777 $11.350 $11.369 $12.088

2029 $14.203 $10.709 $10.776 $11.620

2030 $13.589 $10.016 $10.148 $11.118

2031 $12.930 $ 9.274 $ 9.492 $10.582

2032 $12.225 $ 8.471 $ 8.800 $10.008

2033 $11.470 $ 7.607 $ 8.076 $ 9.394

2034 $10.660 $ 6.678 $ 7.321 $ 8.736

2035 $ 9.793 $ 5.681 $ 6.533 $ 8.032

2036 $ 8.864 $ 4.613 $ 5.713 $ 7.277

2037 $ 7.868 $ 3.469 $ 4.858 $ 6.470

2038 $ 6.800 $ 2.247 $ 3.966 $ 5.604

2039 $ 5.656 $ 0.598 $ 2.722 $ 4.677

2040 $ 4.429 $ (1.216) $ 1.368 $ 3.684

2041 $ 3.113 $ (3.211) $ (0.093) $ 2.620

2042 $ 2.194 $ (4.910) $ (1.178) $ 1.971

2043 $ 1.577 $ (6.419) $ (1.989) $ 1.645

2044 $ 1.359 $ (7.655) $ (2.440) $ 1.739


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POLICY CONSIDERATIONS

In reviewing the amendments, the Commission identified the following policy

considerations.

Reduced Benefit Tier. Amendment Number 07223 would have the effect of reducing

the value of retirement benefits for most future members of PSERS and SERS

relative to most current members of the Systems. Amendment Number 07223 would

also lower the normal retirement age to age 55 for most new members, while

increasing employee contributions relative to the benefits earned.

Benefit Disparities. By creating additional, reduced benefit tiers, Amendment

Number 07223 creates the potential for pension benefit inequities in the treatment

of similarly situated public employees, and in some cases, the potential for litigation

brought by members over resulting pension benefit disparities. The complexities

involved in the administration of multiple benefit tiers will also likely add to the

Systems operational and administrative costs.

Further Departure from Actuarial Funding Standards. The proposal would taper

the collared contribution rates implemented under Act 120 for both PSERS and

SERS, further delaying the increases in employer contributions and spreading the

increases over future years. The Commission is well aware of the fiscal challenges

facing the Commonwealth resulting from the increased pension

contributions. However, it must be noted that the tapering of the collared

contribution rates proposed in the amendment will generate additional liabilities for

the Systems in the long term. The short-term effect of the tapering of the collars

would be to further defer the payment of contributions to both PSERS and SERS,

resulting in the additional underfunding of both retirement Systems. This would

also offset the savings realized under the proposal from the establishment of zero-

cost benefit tiers and the proceeds from the pension obligation bonds. The

Commonwealths policymakers must determine whether the further departure from

actuarial funding standards proposed by the amendment is consistent with the

Commonwealths pension plan funding and fiscal management goals.

Pension Obligation Bonds. Amendment Number 07223 authorizes the PSERS and

SERS Boards to apply for pension bonds in amounts up to $6 billion and $3 billion,

respectively, to pay down the unfunded accrued liabilities of the Systems. Based on

the understanding of the sponsors intent, the borrowing would be required to occur

within the first year after the effective date of the proposal. The infusion of the bond

proceeds would have a positive impact on the funding of both the Systems. It must

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be noted that the actuarial cost analyses do not address the costs to the

Commonwealth for debt service on the bonds.

Normal Cost Calculation. PSERS and SERS use somewhat dissimilar methods for

calculating the normal cost rate. Under the SERS method, the normal cost is

calculated based upon the average new entrant to the System. As a result, the

normal cost for SERS would decrease even though the cost of providing benefits to

current members would not change. Because benefits provided to current members

are higher than the benefits provided to members of the new Class QB, the employer

normal cost under SERS would be significantly lower than the average cost of the

benefits provided to current members, and will tend to understate the Systems

normal cost. In the short term, the understated normal cost would generate a

significant unfunded actuarial accrued liability in SERS. In contrast, the normal

cost method employed by PSERS is based on a blending of the normal cost rates of

all active members. This is the traditional method for calculating the normal cost

under the entry age normal actuarial cost method.

The Commission's consulting actuary has indicated that the PSERS method would

be the preferred approach for determining the normal cost for both PSERS and

SERS. This is especially important if the reduced benefit classes are adopted for

new members in order to avoid having a decrease in the normal cost for currentmembers and an increase in the actuarial accrued liability. Under the PSERS

approach, the normal cost and unfunded actuarial accrued liability would not

change for current members, but there would be a reduced normal cost for new

members as they join the system. Thus, the total normal cost would gradually

decline as new members are added and current members retire. Use of the

traditional method would help to achieve the presumed long-term cost reduction

goals of Amendment Number 07223 by both gradually reducing the normal cost and

preventing the creation of additional unfunded actuarial accrued liabilities.

Special Membership Classes. Under the SERS Code, there are a number of specialcategories of public employees entitled to enhanced benefits, reduced

superannuation requirements, or both. These include members of the General

Assembly, the judiciary, enforcement officers and certain other hazardous duty

personnel. Under Amendment Number 07223, there are no special benefit

provisions for several of these groups of employees. The uniform benefit level for

Class QB would result in a major reduction in the value of employer-provided

POLICY CONSIDERATIONS (CONTD)

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benefits for these groups of employees in the future and would result in significant

benefit disparities between similarly situated employees.

Adequacy of Disability and Death Benefits for Hazardous Duty Personnel.

Historically, it has been the practice of the Commonwealth to provide special

disability and death benefits to public safety employees due to the hazardous nature

of such employment. Amendment Number 07223 represents a major departure from

past practice by providing no such special benefits for hazardous duty personnel.

Due to the hazardous nature of their duties, it may be desirable to retain some type

of enhanced benefit for hazardous duty personnel in the form of special in-service

death, disability or retirement provisions.

Benefit Disparity among Hazardous Duty Personnel. By implementing a reduced

benefit tier for new hazardous duty employees while exempting members of the

Pennsylvania State Police, the proposal creates the potential for benefit inequities in

the treatment of similarly situated public employees that may result in employee

bargaining disputes and subsequent litigation over benefit disparities.

Personnel Recruitment and Retention. One unintended effect of Amendment

Number 07223 may be to decrease the attractiveness of public employment,

particularly among certain subgroups of employees who have traditionally receivedenhanced retirement benefits. The consulting actuary for PSERS estimates the

value of the cash balance benefit to be half of the defined benefit available under Act

120. Policymakers must determine whether the benefit provisions of Amendment

Number 07223 are consistent with the Commonwealths long-term personnel

management goals.

COMMISSION RECOMMENDATION

The Commission voted to attach the actuarial note to the amendments, recommending that

the General Assembly and the Governor consider the policy issues identified above.

POLICY CONSIDERATIONS (CONTD)

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28/177

Mr. James L. McAnenyJuly 27, 2014Page 2

From our analysis the cost savings patterns will be very different between the two Systems because of the differing methods of fundingand amortization of the unfunded liability. Typically under generally accepted funding methods a new tier of benefits results in noimmediate savings and takes effect over time as new entrants replace the existing workforce with the lower cost benefits. Howeverunder SERS the CB plan normal cost rate is defined by Hay as zero and applied to all active participants. In our analysis we assumedthe Legacy DB members continue to have a normal cost rate at the current level, unaffected by the CB plan for new members.

There are some general concerns over the magnitude of the long term savings for SERS and PSERS demonstrated by the worksubmitted by the Systems actuaries. The Systems actuaries assumed an investment return assumption of 7.5% during the projectionperiod. In the private sector cash balance retirement plans are designed to significantly reduce investment risk through asset allocationstargeted to secure a high rate of probability the returns each year will exceed the guaranteed crediting rate. In this case the anticipatedinvestment target return is 4%. If this is not part of the CB plan design, the Systems take on additional risk. If that investment risk isnot measured, by continuing to assume a long term average return rate of 7.5%, the cost savings of the CB plan is overstated.

Conversion to a CB plan is typically addressed by selecting a low interest crediting rate and by investing the assets conservatively sothat they are not subject to the current level of market volatility. Therefore, over time, we would expect the underlying discount rate andlong term investment return rate to gradually decrease as the cash balance accounts become larger relative to the legacy defined benefitplan liabilities. We suggest SERS and PSERS demonstrate the potential implications on cost based on more conservative investmentassumptions.

Another demonstration of the cost implication in the valuation of a CB plan is that by projecting cash balance accounts forward at 4%and discounting the final accumulated account balance backward by 7.5%, the actuarial liability for these benefits become distortedrelative to the expected accumulated value. This is particularly true when HB 1353 provides that 50% of the return in excess of 5%supplements the cash balance accounts suggesting that not all the returns of the average assumed rate will be available for funding butwill be dedicated to provide enhanced benefits. In these terms a 7.5% discount assumption only provides a return of 6.25% under alayman interpretation of the provisions related to the CB plan liabilities with 1.25% of the return increasing the plan liability. If themethod to determine the liabilities of the CB plan is to project the CB account with interest, then based upon the asset return assumptionof 7.5%, the cash balance interest assumption could be as much as 5.25% after reflecting the excess interest.


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It should be pointed out that this funding methodology in cash balance plans, whereby the cash balance accounts are projected forwardat the interest crediting rate and discounted backward at the higher discount rate was prohibited by the IRS for private sector pensionplans before single employer plans had to comply with using the corporate bond yield curve discount rates for funding under thePension Protection Act.

For SERS specifically there is also concern over the long term savings due to the actuarial cost method used. Hay uses a variant of theentry age normal cost method that calculates the normal cost based on the benefits and demographics of the new hires for this plan. TheCB plan reduces benefits for Class OB members; therefore the normal cost as a percent of pay will be lower for Class OB members thanthat of the current members. In fact, based on the SERS actuarys analysis, the normal cost, as a percent of pay, is expected to be 0%for Class OB. This is due to two features of the proposed CB plan design:

First, the cash balance accounts are credited with the statutory interest rate of 4% plus a maximum of 1.25% in excess

interest, for a total maximum interest of 5.25% which is less than the assumed investment return of 7.5%. Applying this

technique and these assumptions, this difference of 2.25% is available to cover the annual cost of the CB plan.

Second, the cash balance account is converted to a life annuity based on the statutory interest rate of 4%. The difference

between the 4% statutory interest rate and the assumed investment return of 7.5% is also used to fund the plan.

According to Hay, the combination of the two results in a normal cost of 0% of pay due to the assumption that the return in excess of

the contributions pays the employers portion of the benefit.

This method applies the Class OB normal cost rate of 0% to all members, regardless of the benefits that apply to the other membershipclasses resulting in an illogical and potentially dangerous misrepresentation of the overall costs of SERS. The total present value ofbenefits has not changed for the other membership classes, so this causes the actuarial liability for current members to increase eventhough their benefits have not changed. It has the effect of deferring employer contributions into the future because the employernormal cost contribution will be lower and the increase in the liability due to the cash balance retirement plan is amortized over 20years which is a longer period of time than if it were funded through the normal cost.


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Due to this methodology, any cost savings under the CB plan will be further overstated by pushing the legacy cost out further. Thismethod also lacks transparency and is potentially misleading because it makes it appear as if there is no annual cost to provide benefitsunder the plan based on the application of this method.

This variation of the entry age normal method arose during a period when benefits were being increased and resulted in a more

disciplined funding approach. However, it does not work well in reverse with benefit cutbacks and has been criticized when applied tonew lower tier benefits because it results in lower initial contributions and as a result defers payment into the future creatingintergenerational equity issues. Under GASB 67 and 68, plans must use the traditional individual entry age normal funding method.

There is also concern over the funding provisions of HB 1353. First, HB 1353 reduces the pension contribution collars to 3% for thenext five years which has the effect of deferring costs into the future. Second, a significant portion of the savings is derived from thespecial funding for SERS and PSERS. While the special funding provides a savings to the Systems, there is the potential for there to bea net cost to the Commonwealth. The idea of using pension obligation bonds to fund the Systems assumes the investments will earn ahigher return than the interest rate on the bonds, producing an overall net savings. In a transparent transaction the present value of thetwo sets of cash flows, the funds deposited into the pension fund and the debt service of the funds for the Commonwealth areequivalent. Therefore any stated savings from the transaction is a measure of the risk transfer by presumably investing funds at a higherrate than the debt service. However the debt service is required and the investment rate in the pension fund is an expectation not aguarantee. There is the chance that the higher expectation over debt service will not materialize. The cash balance plan createsadditional risk since as previously mentioned, investments are typically invested conservatively. The Systems should consider preparing

a stochastic analysis to determine the risk associated with the additional one time lump sum and the potential for this transaction toproduce a net cost to the Commonwealth.

Regarding benefit security, the proposed CB plan design will provide lower retirement benefits for the new membership classes. Bucksanalysis showed that retirement benefits for Class T-G members will be approximately one-half of the benefits for Act 120 memberswith similar service, salary and retirement ages. SERS should consider providing a similar analysis.

The potential projected savings, over the 30 year projection period is summarized in the following table. The results shown by Buck andHay reflect thebenefit and funding provisions of HB 1353. Cheirons results are shown under two cash balance scenarios (both whichinclude the funding provisions of HB 1353). The first scenario assumes the investment return assumption remains at 7.50%. The second


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scenario assumes the investment return assumption is blended to reflect a gradual reduction of market risk that the fund is exposed to,thereby gradually reducing the investment return assumption. In addition, the last scenario reflects only the special funding provision ofHB 1353.

Below we provide a summary description of the CB plan, and projections of the implications of this new benefit structure on the fundedstatus of the Systems. From our projections the bulk of the savings is through cost reductions in the future, anticipated by the emergingnew entrant classes for each System.

Summary of the Cash Balance Retirement Plan

Amendment 07223 to House Bill 1353 (HB 1353) creates a new membership class for SERS (Class OB) and PSERS (Class T-G) for

employees hired on or after January 1, 2015 for SERS and July 1, 2015 for PSERS and for former active members returning to activeservice. These new membership classes will be would be covered by a cash balance retirement plan (CB plan). However, State Police andmembers of the judiciary hired on or after January 1, 2015 and former active State Police and members of the judiciary returning to activeservice will remain in their current membership classes and be covered by the current legacy defined benefit plan (Legacy DB plan). Inaddition, HB 1353 will revise certain funding provisions of SERS and PSERS.

In general, the following cash balance provisions would apply to Class OB and Class T-G members:

Member contributions7% of compensation credited to the cash balance accounts.

Employer contributions 4% of compensation credited for service less than 15 years and 5% of compensation for 15 or more

years of service credited to the cash balance accounts.

Buck Hay 7.50% Blended SpecFundPSERS 26.8$ N/A 19.8$ 18.6$ 16.4$SERS N/A 15.3$ 10.7$ 8.6$ 8.2$

Cost Savings (In Billions)

Cheiron


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Statutory interestAccumulated balances in the cash balance accounts for non-annuitants are credited with 4% interest each year.

This is also the interest rate used to convert cash balance accounts into annuities.

Excess interest Beginning in 2018, active members are eligible to receive 50% of any excess interest earned by the Systems.

Excess interest is the five year average (phased in over the first five years) of the Systems actual investment returns overor below

5%. The excess interest is allocated proportionally between the cash balance accounts and the Legacy DB liabilities.

Eligibility for superannuation Age 55. The benefits paid on or after superannuation are monthly annuities that are actuariallyequivalent to the cash balance accounts. Actuarial equivalence for this purpose will be based on the 4% statutory interest rate.

Benefits paid outprior to superannuation are lump sum distributions of the members contributions with interest.

Eligibility for death benefitsImmediate. Beneficiary receives a lump sum of the cash balance account.

Eligibility for disability benefits 5 years The benefits paid are monthly annuities that are actuarially equivalent to the cash

balance accounts.

In general, the following opt-inprovisions would apply to current members of SERS and Class T-D members of PSERS who elect alower member contribution rate in exchange for lower Legacy DB benefits:

Member contributionsReduced by 1%.

Final average salaryFor Legacy DB plan, final average salary based on 5 years for all service.

Option 4 benefit Calculated using actuarial cost neutral factors. Members can still elect the Option 4 form of payment which

allows members to take a refund of member contributions with interest at retirement in exchange for a reduced monthly annuity.HB 1353 changes the definition of actuarial equivalence for this purpose from the statutory 4% interest rate to the rate adopted by

the Board for actuarial valuation purposes.

In general, the following funding provisions will apply:

Contribution collars HB 1353, as written, reduces the pension contribution collars to 3% for fiscal years July 1, 2014 through

June 30, 2019. However, based on instructions from the Public Employee Retirement Commission, the contribution collars will be

delayed one year so that the 3% contribution collars will be effective for fiscal years July 1, 2015 through June 30, 2020. The

contribution collars will end the earlier of June 30, 2020 or when the required contribution is less than the collared contribution.


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For SERS, the change in liability resulting from the CB plan will be funded over 20 years as a level dollar amount. Future changes

in liability for SERS continue to be amortized over 30 years as a level dollar amount.

For PSERS, the 10 year asset smoothing method would be constrained to be within 30% of the market value of assets.

Authorization to apply for special funding HB 1353 allows SERS and PSERS to apply for additional funding of up to $3 billion

and $6 billion dollars, respectively.For PSERS, the additional funding is contingent on the percentage of members who make an

election to opt-in to the benefits described above. However, based on discussions with the Public Employee RetirementCommission, this is a drafting oversight, and the special funding will not be conditioned on members opting-in to the benefits

described above.

Analysis

The implications of the CB plan are to change the cost of pension benefits over time and improve the funded status. To illustrate theimplications we were provided with the expected projected salary and benefit payouts from the SERS and PSERS actuaries to prepare ourown model projections. We did not have actual census data and our methodologies in projection will be different from the SERS andPSERS actuaries which will result in numerical differences in values. However the projections are effective in providing insight into thelong term trends of the Systems, the implications of the CB plan and when the savings are anticipated. For PSERS the results exclude thehealthcare premium assistance. Our projections under the existing law are slightly different than what was shown in prior costs notessince we refined our model based on available information we received subsequent to those cost notes; however, the changes are notmaterial.

Our first four graphs (Graphs 1A 1D) are to set the stage in projecting the assets and liabilities based on a stationary population andassuming new members continue to participate in SERS and PSERS under the existing law. The first of two types of graphs we will beusing in our analysis represent the liabilities, shown as the bars, and assets, shown as the lines, over time. The numbers at the top of thebars show the funded status as the actuarial assets divided by the liabilities over time. For example in the year 2020 SERS is projected tobe 63% funded if all of the assumptions including the current 7.5% investment return are exactly realized each year. This is alsopredicated on the actuarially determined contribution being contributed each year. Our projections show SERS and PSERS reaching 98%and 96% funded, respectively, by the end of the 30 year projection.


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Graph 1A - State Employees Retirement SystemExisting Law

($15)

$5

$25

$45

$65

$85

$105

$125

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

Billions

Actuarial Liability Actuarial Assets Market Assets


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Graph 1B-Public School Employees Retirement SystemExisting Law

The next graphs in our analysis show the projection of contributions breaking out the member contributions and the employercontributions each year under the existing law. The total normal cost rate represents the cost of the benefits earned each year as apercent of payroll. The existing law rate represents the current employer total cost as a percent of payroll to provide a comparison withprojections that demonstrate costs under the hybrid plan.

For SERS, the total normal cost rate remains at 11.3% of pay over the projection period because SERS uses a variation of the entry agenormal cost method where the normal cost is based on the benefits and demographics of the new hires. For PSERS, the traditionalindividual entry age normal cost method is used to calculate the normal cost. Therefore, for PSERS, the normal cost decreases slowlyover time as more members are covered under the Act 120 plan provisions.

The balance of the cost represents the amortization of the unfunded liability and the steep ramping up of costs initially is the applicationof contribution collars which limit the contribution increase each year to no more than 4.5% until the actuarially determinedcontribution rate is lower. At that point we project the employer costs will be approximately 30% of payroll for SERS and PSERS. On


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Graph 1D - Public School Employees Retirement SystemExisting Law

With the current status of SERS and PSERS as background we then apply the provisions of the CB plan for the new membershipclasses. We have shown the results under two separate cash balance scenarios. In the first scenario we assumed a 7.5% discount ratesimilar to the cost notes prepared by the Systems actuaries. This scenario assumes the entire excess interest will be provided to the cashbalance account, creating a total interest crediting rate of 5.25%.

In the second scenario we assumed the discount rate will be a blended discount rate, reflecting the proportion that the cash balanceliability is to the total liability of the plan. Therefore, the discount rate will start out at 7.5% and will decrease over time as more of theliability is covered under the CB plan, ultimately reaching just over 4.0% when all of the members are covered under the CB plan. Atthe end of the 30 year projection period, the discount rate for SERS and PSERS is approximately 6.3% and 6.7%, respectively. Thisscenario assumes the excess interest will be approximately 0.75% on average with a total interest crediting rate of 4.75%.


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All other assumptions are implicitly based upon the assumptions used by Hay and Buck for their analysis, due to reliance upon the cashflows, pay projections, liabilities, and normal cost information provided.

For simplicity, we assumed new members enter the CB plan each year based on the average entry age of the current Legacy DB planmembers and the average attained age of the members in the cash balance plan will increase each year until ultimately the attained agein the cash balance plan reaches the same average attained age as in the Legacy DB plan. We assumed an average retirement age of 65

in the CB plan. For SERS we also assumed that current members would have a normal cost of 5.01%, which is the normal cost of theLegacy DB structure. Both scenarios reflect the 3% collars under HB 1353 and assume $3 billion in special funding for SERS and $6billion in special funding for PSERS in fiscal year 2015. Over the 30 year projection period there is a net cost savings for both SERSand PSERS under both scenarios.

The following set of graphs show the funded status under the CB plan assuming a 7.5% discount rate.


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Graph 2A - State Employees Retirement SystemCB Plan 7.5%/Funding Reforms

($15)

$5

$25

$45

$65

$85

$105

$125

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

Bill

ions



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Graph 2B - Public School Employees Retirement SystemCB Plan 7.5%/Funding Reforms

Looking at the funding requirements we now add the emerging CB plan costs with the Legacy DB plan costs. By the end of the 30 yearprojection, the employer contribution as a percent of total employee payroll is 3.3% and 4.6% for SERS and PSERS, respectively. Theblack line shows the level of costs under existing law to illustrate how the cost savings is anticipated to emerge. Member contributionsinclude both the CB plan and Legacy DB plan member contributions. A significant part of the savings is attributable to the specialfunding of $3 billion and $6 billion for SERS and PSERS, respectively.

($25)

$25

$75

$125

$175

$225

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

Billions



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Graph 2C - State Employees Retirement SystemCB Plan 7.5%/Funding Reforms


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Graph 2D - Public School Employees Retirement SystemCB Plan 7.5%/Funding Reforms


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The next set of graphs assumes a blended discount rate that decreases over time. Using a lower discount rate will reduce the savingsover the 30 year period.

Graph 3A - State Employees Retirement SystemCB Plan Blended/Funding Reforms

($15)

$5

$25

$45

$65

$85

$105

$125

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

Billions



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Graph 3C - State Employees Retirement SystemCB Plan Blended/Funding Reforms


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Graph 3D - Public School Employees Retirement SystemCB Plan Blended/Funding Reforms

The next set of graphs show the funded status and funding requirements under the current plan and funding provisions except that it wasassumed that there would be special funding of $3.0 billion and $6.0 billion for SERS and PSERS, respectively. As can be seen by the

projections, the special funding does not materially improve the funded ratio after 30 years because the net effect is to reduce the costover a 30 year period for SERS and a 24 year period for PSERS.


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Graph 4A - State Employees Retirement SystemSpecial Funding Only`

($15)

$5

$25

$45

$65

$85

$105

$125

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

Billions



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Graph 4B - Public School Employees Retirement SystemSpecial Funding Only

($25)

$25

$75

$125

$175

$225

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

Billions



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Graph 4C - State Employees Retirement SystemSpecial Funding Only

0%

10%

20%

30%

40%

50%

60%

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

Pe

rcentof

Pay Member Rate Employer DB Rate Total NC Rate Existing Law Rate


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Graph 4D - Public School Employees Retirement SystemSpecial Funding Only

We have included tables at the end of this report showing the results in tabular form for comparative purposes.

Commentary on the Analysis Prepared by Hay and Buck

Hay prepared an analysis of the cost impact of the HB 1353 on SERS and Buck provided a similar analysis for PSERS. Cheironreviewed Hays cost note dated June 6, 2014 and Bucks cost note dated July 24, 2014.

The cost notes from Hay and Buck both showed cost savings under HB 1353. For the period 2015 through 2044, Haysresults showedcumulative savings of $15.3 billion for SERS and Bucksresults showed cumulative savings of $26.8 billion for PSERS. A significantpart of the savings is due to the special funding of $3 billion and $6 billion for SERS and PSERS, respectively. However, the savings toSERS and PSERS generated by the special funding will be offset by the interest the Commonwealth pays on the pension obligation

0%

10%

20%

30%

40%

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60%

2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041 2043

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rcentof

Pay Member Rate Employer DB Rate Total NC Rate Existing Law Rate


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Mr. James

perc actuarial note july 2014

Documents